ECB To Hold Rates Steady Despite Strong Euro

2/6/2013 9:00 AM ET

The European Central Bank is expected to maintain status quo on Thursday as it waits for the positive trends in the financial markets to trickle down to the real economy and to take stock of the harm caused by a stronger euro.

While ECB President Mario Draghi is unlikely to announce any further stimulus measures, he is widely expected to embark on verbal intervention to halt a further appreciation of the euro.

"The Bank's faith that improving financial market conditions will soon generate economic growth might prove to be misplaced," Jennifer McKeown, Senior European Economist at Capital Economics said. "With other central banks still upping their support, the ECB risks losing out in a currency war."

The central bank of 17 nations will likely maintain the refinancing rate at a record low 0.75 percent for a seventh consecutive month in February, following the Governing Council meeting in Frankfurt on Thursday. The deposit rate is expected to be held at zero and the marginal lending facility rate at 1.50 percent.

Draghi will hold his regular press conference at 8.30 am ET. Markets would keenly watch his comments for new code words directed at stemming the rise in the euro.

Danske Bank analysts expect Draghi to argue that the early repayment of 3-year loans, known as LTROs, by banks and the resultant rise in interest rates is a healthy sign of normalization rather than premature de facto monetary policy tightening.

The euro hit a 14-month high against the dollar on February 1. The currency declined to 1.3508 against the dollar as of 7.54 am ET today as traders eye tomorrow's ECB meeting.

The yen weakened to a near three-year low of 94 against the dollar today amid speculation that the government may accelerate the appointment of a new central bank chief. The euro rose to 127.71 against the Japanese currency today.

Analysts expect the yen weakness to continue for some time as the government and the central bank under a new chief are likely to favor aggressive easing.

Meanwhile, the strong euro exchange rate has emerged as a new risk to the euro area economic outlook, ING Bank Senior Economist Carsten Brzeski said.

"In our view, the stronger euro has put a foot into an already closed door towards another rate cut," he said. "Even if the stronger euro in itself will not be a target variable for the ECB, the economic impact could eventually lead to some action."

One of the reasons behind the euro appreciation is the fact that ECB's balance sheet is shrinking due to LTRO repayments, while those of other major central banks are widening owing to further monetary stimulus.

The exchange rate has been a topic of contention this week. Speaking at the European Parliament on Tuesday, French President Francois Hollande said that Europe must determine a realistic medium term exchange-rate for the euro. The single currency must not be allowed to fluctuate according to the mood of the market, he added.

A stronger euro could hurt Eurozone exporters by reducing their competitiveness. Weak exports could lead the 17-nation economy into a deeper recession.

Calls for exchange rate manipulation faces stiff opposition from euro area members like Germany. Responding to Hollande's comments yesterday, German Economy Minister Philipp Roesler said the objective must be to strengthen competitiveness and not to weaken the euro.

It is also likely that Draghi would face questions regarding the Italian banking scandal involving the lender Monte dei Paschi. He was at the helm of the Bank of Italy between 2006 and 2011. The lender is accused of hiding losses incurred in derivatives trading between 2006 and 2009. The bank is expected to reveal the loss figure, as early as today, which is expected to be around EUR 700 million.

The latest rate-setting session also comes at a time when investor confidence is hurt by the corruption scandal in Spain and concerns over the rising popularity of former premier Silvio Berlusconi in Italy, ahead of elections this month.